Editor’s Letter

Strategic and tactical fixed-income asset allocation requires an assessment of the incremental expected return (risk premium) and risk on each investment alternative. The assessment is further complicated with corporate bonds by the decomposition of spreads into default and term risks with their associated correlation. We begin this issue of The Journal of Fixed Income with an article by Attakrit Asvanunt and Scott Richardson that provides substantial evidence on the isolation of the time-varying credit risk premium and its contribution to the asset allocation decision.

Estimating the probability of default is crucial to risk management. In the next article, Andreas Blöchlinger derives a methodology for determining unbiased estimates of the probability of default by comparing expected with realized default rates. In the following article, Shengguang Qian, S. Lakshmivarahan, and Duane Stock present a structural bond model that incorporates default and the interaction with alternative call features, resulting in distinctly different par coupon term structures. As expected, call option value declines as credit quality deteriorates.

Since the beginning of the financial crisis in 2008, market stress has resulted in greater liquidity risk. In the next article, Matteo Aquilina and Felix Suntheim present evidence on the evolution of liquidity in the U.K. corporate bond market. They document that since the 2009–2010 low, market liquidity has not deteriorated in recent years. The financial crisis has also changed the interest rate swap market. In the following article, Ayoub Gargouri, Van Son Lai, and Issouf Soumaré propose an interest rate swap valuation methodology that employs overnight index swap discounting for a riskless rate with a credit valuation adjustment for counterparty default risk, volatility of the expected exposures, and wrong-way risk.

Finally, Doina Chichernea, Alex Petkevich, and Kainan Wang show that corporate bond investors react to accounting signals relevant to the probability of default. Furthermore, they employ a trading strategy between investment- and noninvestment-grade bonds to exploit this relationship that generates economically and statistically significant returns.

We hope you enjoy this issue of The Journal of Fixed Income. Your continued support of the journal is greatly appreciated.

TOPICS: Fixed income and structured finance, fixed-income portfolio management, portfolio theory

Stanley J. Kon

Editor

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